Service on Finance and Development (Mar16/02)
11 March 2016
Third World Network
New year sees turbulent start to financial markets
Published in SUNS #8196 dated 8 March 2016
Geneva, 7 Mar (Kanaga Raja) -- The uneasy calm that had reigned in
the financial markets in late 2015 gave way to a turbulent start this
year, witnessing one of the worst stock market sell-offs since the
2008 financial crisis, the Bank for International Settlements (BIS)
said on 6 March.
In its latest Quarterly Review of March 2016, the Basel-based central
bank of the world's central banks said that markets at first focused
on slowing growth in China and vulnerabilities in emerging market
economies (EMEs) more broadly.
"Increased anxiety about global growth drove the price of oil
and EME exchange rates sharply lower and fed a flight to safety into
core bond markets. The turbulence spilled over to advanced economies
(AEs), as flattening yield curves and widening credit spreads made
investors ponder recessionary scenarios."
In a second phase, the deteriorating global backdrop and central bank
actions nurtured market expectations of further reductions in interest
rates and fuelled concerns over bank profitability.
In late January, BIS noted, the Bank of Japan (BoJ) surprised markets
with the introduction of negative interest rates, after the European
Central Bank (ECB) had announced a possible review of its monetary
policy stance and the Federal Reserve issued stress test guidance
allowing for negative interest rates.
On the back of poor bank earnings results, banks' equity prices fell
well below the broader market, especially in Japan and the euro area.
Credit spreads widened to a point where markets fretted about a first-time
cancellation of coupon payments on contingent convertible bonds (CoCos)
at major global banks.
"Underlying some of the turbulence was market participants' growing
concern over the dwindling options for policy support in the face
of the weakening growth outlook. With fiscal space tight and structural
policies largely dormant, central bank measures were seen to be approaching
their limits," said BIS.
In some on-the-record remarks on 4 March on the eve of the launch
of the Quarterly Review, Mr Claudio Borio, Head of the BIS's Monetary
and Economic Department, said: "The tension between the markets'
tranquillity and the underlying economic vulnerabilities had to be
resolved at some point. In the recent quarter, we may have been witnessing
the beginning of its resolution."
He said that the new year greeted investors with one of the worst
sell-offs on record. Investors had just breathed a sigh of relief
following what had turned out to be an uneventful, if historic, 25
basis point increase in the federal funds target range in mid-December
- the first hike since the overnight rate had been pushed to zero
seven years earlier, marking the longest post-war phase of immobility.
Just two weeks later, markets tumbled. As in the summer, the trigger
was China, as signs of a slowdown there hinted at broader emerging
Equity prices took a dive worldwide, volatilities soared, credit spreads
widened, emerging market currencies fell, especially vis-a-vis the
US dollar, and the oil price sank to new lows, below the troughs reached
during the Great Recession.
In turn, these developments fed pessimism about other economies, notably
the United States, thus spreading gloom further.
According to Mr Borio, this was only the first phase of the turbulence.
A second, briefer but perhaps more worrying episode in the first half
of February focused on the health of global banks.
Their valuations, which had been under pressure for quite some time,
plunged to new lows while their credit default swap (CDS) spreads
Price-to-book ratios hovered around levels not seen since the most
acute phase of the crisis. Disappointing global growth prospects and
earnings announcements added to jurisdiction-specific worries, such
as stubbornly high non-performing loans and regulatory-driven concerns
about coupon suspensions for contingent convertible bonds (CoCos)
in the euro area.
"But the main source of anxiety was the vision of a future with
even lower interest rates, well beyond the horizon, that could cripple
banks' margins, profitability and resilience," he said.
Anxiety grew and spread following the Bank of Japan's decision to
adopt negative policy rates. At its peak, more than US$6.5 trillion
worth of sovereign paper was trading at negative yields - stretching
once more the boundaries of the unthinkable. Only more recently have
markets regained a certain composure, he added.
"Against the backdrop of a long-term, crisis-exacerbated decline
in productivity growth, the stock of global debt has continued to
rise and the room for policy manoeuvre has continued to narrow - a
set of factors that might be termed the ‘ugly three'."
Mr Borio further said that the latest turbulence has hammered home
the message that central banks have been overburdened for far too
long post-crisis, even as fiscal space has been dwindling and structural
Despite exceptionally easy monetary conditions, in key jurisdictions
growth has been disappointing and inflation has remained stubbornly
"Market participants have taken notice. And their confidence
in central banks' healing powers has - probably for the first time
- been faltering. Policymakers too would do well to take notice,"
According to the BIS report, on 16 December, the Federal Reserve raised
the target range for the federal funds rate, after eight years of
monetary policy easing across the major currency areas.
Even after the increase, the US monetary policy stance remained highly
accommodative: the increase in the federal funds target range was
minimal - 25 basis points - and the stock of assets acquired over
years of large- scale asset purchases was left unchanged.
The Federal Open Market Committee (FOMC) signalled that the shortfall
of inflation below its 2% objective, and uncertainty surrounding economic
conditions more broadly, were expected to warrant only gradual increases
in the federal funds rate.
"Nonetheless, the decision marked a turning point in an era of
extraordinary monetary accommodation," said BIS.
It noted that when the first US rate hike eventually came, it hardly
caused a stir. The onset of the tightening cycle had long been expected,
starting as early as May 2013, when expectations of an eventual "tapering"
of asset purchases had reverberated through global financial markets.
In the days before 16 December 2015, the futures-implied probability
of a December lift-off was near 80%, reflecting confidence in the
US economic outlook.
"Apart from temporary volatility around the announcement date,
the yield curve barely moved. Equity markets traded sideways, as one
source of uncertainty was resolved. However, other sources of uncertainty
soon appeared, and have come to dominate the scene."
FINANCIAL MARKETS BECOME UNSETTLED
According to the BIS report, the deterioration of global growth prospects
unsettled financial markets from the start of the year.
The first phase of turbulence centred on anxiety over global growth
in EMEs, and China in particular. China's reported growth slowed to
6.9% in 2015, the lowest official rate since 1990. Consensus forecasts
for 2016 had been falling continuously over the previous 12 months.
The softness in manufacturing had long been offset by a growing service
sector, but in December the services PMI stood at its weakest level
in 17 months.
Concerns about a slowdown in Chinese manufacturing spread to other
EMEs, for which 2016 growth forecasts had been falling rapidly in
the second half of 2015.
"Worries about manufacturing were not limited to Asia: the strength
of the US dollar and low oil prices cast a pall over the outlook for
US manufacturing, which weakened relative to the non-manufacturing
sector. Indeed, the growth outlook for all major economic regions
continued to deteriorate."
Against this backdrop, said BIS, disappointing news from China triggered
market turbulence on the very first trading day of the year.
As a closely watched manufacturing index pointed to renewed sectoral
weakness, stock markets sold off in both advanced and emerging economies.
As the Shanghai Composite plunged over 15% in the first two weeks
of the year, major AE stock markets dropped by almost 10%.
During the first week alone, trading in China was halted twice in
response to new market mechanisms that stop trading when losses reach
a certain threshold, adding to market distress.
"Implied volatilities soared to peaks comparable to those observed
in August 2015, and well above the subdued levels of the previous
three years. But in contrast to that short-lived episode, the rout
in early 2016 lasted for several weeks."
BIS said that growing concern about the global economic outlook, in
turn, led to further losses in commodity markets.
The prospect of weaker demand, on top of the supply glut that had
become apparent over the past 18 months, hit crude oil markets hard.
Oil prices extended the slide of the second half of 2015, falling
below $30 per barrel for several days before rebounding to slightly
above that level.
Brent settled 70% below the average nominal price observed between
mid-2010 and mid-2014, the peak of the long boom in commodity prices
which spanned over a decade.
"In fact, current oil prices barely exceed the average nominal
price levels of the five years preceding 2002, right before the onset
of the commodity price boom."
BIS said that the heavy debt burden of producers (especially US shale
companies) may have exacerbated the price decline.
Lower oil prices reduce the cash flows from current production and
raise the risk of illiquidity and possibly debt defaults.
"Firms facing such strains may have maintained or even raised
production to preserve liquidity and reduce debt, thereby contributing
to further price declines. These forces may have been at play in the
US market, where the large drop in oil prices went hand in hand with
continuous increases in oil inventories."
BIS further said that in the midst of a global risk asset sell-off,
a general flight to safety strengthened the US dollar.
Currencies of EMEs and commodity exporters tested new lows before
finding support in mid-January at levels about 3% below year-end.
Concerns about renminbi depreciation also stirred foreign exchange
On 11 December 2015, the People's Bank of China introduced the China
Foreign Exchange Trade System (CFETS) reference basket, signalling
a shift from a singular focus on the US dollar.
Between August 2015 and late January 2016, the renminbi depreciated
by 6% against the US dollar, while staying broadly stable vis-a-vis
the CFETS basket.
The country's foreign exchange reserves dropped by more than $300
billion over the same period, at a seemingly accelerating pace that
unnerved investors, BIS added.
"Expectations of further depreciation may have contributed to
the sell-off in the domestic stock market, which in turn put further
pressure on the currency. The combined impact of lower oil prices
and a stronger US dollar has put substantial pressure on many EMEs
at a time when the tide of global dollar liquidity appears to be turning."
Global credit markets were also riled by turbulence. The low interest
rate environment of the past few years had gone hand in hand with
a search for yield that eased credit conditions, in particular for
As market turbulence spread, AE high-yield credit came under unusual
pressure, after having been buffeted by increasing headwinds since
The widening of spreads was particularly sharp for US high-yield debt,
which was weighed down by the under-performance of energy companies
and fears of a rise in default rates.
By comparison, said BIS, the widening of corporate spreads was more
moderate in Europe, with high-yield spreads halfway to their 2011
The divergence between the investment grade spreads across the two
regions coincided with the onset of the oil price plunge in mid-2014,
possibly reflecting concerns over contagion from the oil sector to
other parts of the US economy.
Sovereign credit spreads in EMEs also widened during the initial weeks
of 2016, comfortably surpassing the heights recorded in 2011, said
According to the report, the monetary policy landscape across EMEs
varied, reflecting the role played by commodities, exchange rates
and other drivers of inflation.
Central banks in emerging Asia and Europe, whose economies mostly
benefited from the commodity price plunge, kept their monetary policies
unchanged despite substantial currency depreciation.
Commodity exporters, by contrast, tightened or signalled an inclination
to tighten rates, as currency depreciation triggered strong inflationary
pressures in spite of slowing economic activity. For most countries,
however, the challenging global backdrop for exchange rates left limited
space for monetary stimulus.
SECOND PHASE OF TURBULENCE
BIS further noted that the ongoing financial turbulence against a
weakening global backdrop gave way to a second phase of turbulence,
in which markets focused on the possibility that central banks could
drive interest rates further into negative territory and, in the process,
add to the persistent weakness in bank profitability.
As turbulence rippled through emerging and advanced financial markets,
the resulting flight to safety helped flatten yield curves in core
By late January, the term spread between the 10-year US Treasury bond
and the three-month bill had dropped more than 50 basis points from
the end of 2015 and the comparable spread for German bunds retreated
by almost 40 basis points. In the past, flattening yield curves and
widening credit spreads have often heralded weakness in economic activity.
"These developments sowed doubt among market participants about
the positive outlook for the US economy, on which the Federal Reserve
had predicted the December lift-off. External weakness, a strong dollar
and widening credit spreads threatened to smother the recovery."
With this new backdrop, said BIS, market expectations of future rate
hikes declined to a point that became inconsistent with the prospect
of three to four rate increases in 2016 implied by FOMC participants'
monetary policy assessments.
By early February, the probability of a rate hike in March had dropped
from 50% to near zero, and even a June hike came to be regarded as
unlikely. The turbulence led markets to price in a very gradual pace
In contrast to expectations at the time of the December lift-off,
by late January markets expected the federal funds rate to stay below
1% throughout 2017, and in February the expected pace of tightening
fell even further.
"Policymakers in major AEs reacted to these developments with
moves that were taken as pointing towards further accommodation."
At its January meeting, the FOMC acknowledged the global financial
turbulence and possible repercussions on the US economy, but did not
signal a change to the previous guidance. But on 28 January markets
took note of the Fed's announcement of the guidelines for the 2016
banking stress test, which asked banks to consider the potential impact
of negative Treasury bill rates as part of a "severely adverse
The BoJ surprised the markets on 29 January by introducing negative
interest rates charged on the excess over required reserves and the
balances accumulated by financial institutions under its quantitative
and qualitative easing programme (QQE) and loan support programme,
and thus joining the ECB and the Swiss National Bank in imposing negative
rates on bank reserves.
The BoJ decision had an outsize effect on financial markets, said
BIS, noting that Japanese government bond yields fell to record lows
across the curve, with negative yields at all maturities out to 10
And after a fleeting rebound in the Japanese stock market and a short-lived
depreciation of the yen, Japanese banks' stock prices fell sharply.
This occurred even though the BoJ measure was designed to minimise
the immediate impact on bank profitability.
As markets digested the implications of negative policy rates in Japan,
they appeared to price in a further set of easing moves more generally.
In a matter of days, the universe of sovereign bonds trading at negative
yields expanded from $4 trillion to more than $6.5 trillion.
By early February, almost one quarter of the outstanding stock of
sovereign bonds in the Merrill Lynch sovereign fixed income index
were trading at negative yields. Among Japanese government bonds,
that share exceeded 60%.
"As the universe of bonds yielding negative rates expanded, markets
became increasingly aware of new constraints and trade-offs that might
limit policy options."
According to BIS, by some reports, the pool of euro-denominated debt
yielding less than the ECB deposit rate (currently at -0.3%) surged
by a third after the ECB's policy meeting on 21 January.
"The rules governing the ECB's asset purchase programme make
such securities ineligible for future ECB purchases. If price dynamics
continued to shrink the universe of eligible securities, the scope
of the asset purchase programme would thus narrow, unless the deposit
rate were pushed further into negative terrain - which, in turn, was
seen as possibly eroding euro area banks' future net interest margin."
As stress reigned in financial markets and the global outlook deteriorated,
tensions spread to the equity and debt obligations of major global
banks. European bank shares had been trailing the broader market since
mid-2015, but the gap widened in 2016. US banks also under-performed
the S&P 500 index by
10% since early January, but Japanese banks plunged 15% vis-a-vis
the Nikkei after the BoJ announcement.
Alongside falling share prices and widening credit default swap (CDS)
spreads, the market for contingent convertible bonds (CoCos) of European
banks took a remarkable dive.
"The limited impact on senior bank debt spreads suggests that
the size or quality of capital buffers were not the primary concern
even as CDS spreads widened. But the possibility that European banks
might have to suspend dividend distributions and CoCo coupon payments
set in motion a dynamic that reinforced the plunge in bank valuations
across asset classes," said BIS.
It added that these developments led market participants to focus
on bank profitability. The doubts markets harbour about the prospects
of European and Japanese banks, in particular, have long been reflected
in the extent to which their share prices traded below their book
Price-to-book ratios slid further during the turmoil, but the persistent
gap between European and Japanese banks vis-a-vis their US peers remained.
Banks' reluctance to pass negative rates on to depositors contributed
to the gradual erosion in net interest income.
At the same time, concern over prospective bank earnings led market
participants to look closely at the likely impact of an extended period
of negative interest rates on bank profitability.
"Underlying some of the turbulence of the past few months was
a growing perception in financial markets that central banks might
be running out of effective policy options. Markets pushed out further
into the future their expectations of a resumption of gradual normalisation
by the Fed. And as the BoJ and ECB signalled their willingness to
extend accommodation, markets showed greater concerns about the unintended
consequences of negative policy rates."
In the background, said BIS, growth remained disappointing and inflation
stubbornly below targets. Markets had seemingly become uncertain of
the backstop that had been supporting asset valuations for years.
"With other policies not taking up the baton following the financial
crisis, the burden on central banks has been steadily growing, making
their task increasingly challenging," it concluded. +